The problem with sticky price models
By Scott Sumner
Bloomberg has an article discussing recent research on price stickiness:
U.S. inflation has been lower than standard economic models would predict throughout the current expansion. Some blame the rise of Amazon.com Inc. for keeping prices low, but there’s another so-called “Amazon effect” that might be more relevant for central bankers.
That’s according to a paper presented Saturday by Harvard Business School economist Alberto Cavallo at the Federal Reserve Bank of Kansas City’s annual symposium in Jackson Hole, Wyoming.
The hypothesis that Amazon might somehow explain the relatively slow pace of inflation is false. If it were true, then high productivity growth would cause inflation to be lower than what one would expect based on growth in nominal wages, but it isn’t. Nominal wage growth is running at only 2.7% over the past 12 months.
The second “Amazon effect’ is more interesting:
Cavallo’s main finding was that competition from Amazon has led to a greater frequency of price changes at more traditional retailers like Walmart Inc., and also to more uniformity in pricing of the same items across different locations. He found that the shift has led to a greater influence of movements in the U.S. dollar exchange rate and gas prices on retail prices. . . .
The implications have subtle significance for monetary policy because so-called “sticky prices” — the notion that sellers aren’t able to change prices right away in response to changes in supply and demand — is precisely what gives interest rates power in mainstream models to have any effect on the economy at all. In those models, if prices adjust instantaneously in response to shocks, then there is no role for central bankers to guide supply and demand back into equilibrium.
It is true that there are models where monetary policy is only effective when prices are sticky. But these are just models and do not describe reality. In the real world, monetary policy has real effects because of the interaction of nominal GDP shocks and sticky wages. Even if all prices were 100% flexible, NGDP shocks would still impact real GDP. Macroeconomics went off course when models were built around price stickiness—that’s not the fundamental issue.
I’d add that it’s a bit odd to talk about there being “no role for central bankers to guide supply and demand back into equilibrium” in a world with no price stickiness. That’s true, but if monetary policy actually were ineffective in influencing real variables due to price flexibility, it would be precisely because supply and demand are always at equilibrium.
The article also discussed the Phillips Curve:
A paper published Thursday by top staff economists at the Fed’s Board of Governors in Washington cautioned against focusing too much on inflation and not enough on unemployment.
Part of the rationale is that in an environment like the present, where the relationship between unemployment and inflation seems to be weaker than it has been historically, external shocks to prices unrelated to domestic demand conditions could lead policy makers astray.
Actually, the relationship has been weak for quite some time:
Again, there is no low inflation mystery. Inflation has been running at levels that are consistent with the Fed’s monetary policy, which has been producing slightly above 4% NGDP growth. The Phillips Curve is not now and never has been a useful way to predict inflation.